Frequently asked questions about LLCs

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Phil Jelsma is a partner at CGS3, a boutique real estate law firm in Carmel Valley, and he specializes in limited liability companies. Don’t know much about those? Jelsma was nice enough to sit down with inewsource to walk through the basics. Here’s an edited conversation.

What is an LLC, or limited liability company?

An LLC is a hybrid entity. It has some of the characteristics of a partnership, primarily for income tax purposes. It’s a pass-through entity and files a partnership income tax return for federal tax purposes. But it has the same liability shield as a corporation.

In many respects it combines the best attributes of two historical types of business entities: limited partnerships and corporations.

Already over my head. Please back up and start over from zero.

OK, from a business standpoint there are three different categories:

There are corporations, there are partnerships — both general and limited — and LLCs.

Corporations and partnerships come out of English common law. They’re both entities that were imported into the United States.

Within the corporate world, for tax purposes, there are two types of corporations: regular corporations, we refer to as C corps, that pay their own tax liability. Then S corporations which are pass-through entities — that is, most of their tax attributes pass through to their owners. So the corporations don’t pay the tax, their owners do.

General partnership is a structure where you have one or more persons in charge of the entity that has liability. Limited partnership structure is where limited partners have a limited role in management and also have limited liability.

OK, back to LLCs.

LLCs essentially took the attribute of pass-through taxation, where there was no entity-level tax, no corporate-level tax, and then combined that with the liability shield of a corporation.

It took the limited partnership and said, ‘What happens if everybody had that liability protection, whether they’re investors or managers?’

Investors and managers?

In LLCs, there’s somebody who makes decisions — we call them a manager.
And then there are often people that are just investors — we call them members.

If it offers the best of both worlds, why wouldn’t every company opt to become an LLC?

Certain professions can’t operate as LLCs.

For example, in California, you can’t practice law as an LLC, you can’t practice medicine as an LLC, you can’t practice accounting as an LLC. I just had to unfortunately tell a client on Friday that you can’t get a real estate broker’s license or a sales license in the name of an LLC. That’s one restriction. Regulatory agencies like state medical boards won’t grant some licenses to LLCs.

Also, publicly traded entities are always corporations.

Why am I finding local people incorporating LLCs in other states? Why would someone want to do that?

Well, one thing that’s relatively unique about LLCs is: you’ve got 50 states and DC, and generally you have 51 different LLC laws. As a result, there will be particular attributes associated with a law that someone is attracted to. And because you can form under any state or DC — and oftentimes under foreign law — and bring the LLC into California and register it to do business here, you don’t need to form under California to operate in California.

Quite honestly, most LLCs you see now are either California or Delaware. Typically a business lawyer, a real estate lawyer or a lender will find some attribute that they like about Delaware law.

Good, we’ve arrived at Delaware. Can you talk about what is so special about Delaware LLCs?

First off, Delaware LLCs pay a flat franchise tax — $300 a year. California LLCs pay a franchise tax of $800 a year plus they pay a gross receipts fee. That’s one difference.

The main difference that people often point to is that Delaware generally allows anyone creating an LLC to, by contract, create their entity. So the rights of the owners are really defined by contract as opposed to being defined by state law.

What does that mean?

The simplest example is in respect to fiduciary duties.

If you look at the California LLC Act, or the LLC acts of most states, they’ll talk about what duties the decision makers, or managers, may have to the LLC and to the members. Historically there have been three components to that: there’s a duty of care, a duty of loyalty and an obligation of good faith and fair dealing.

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The duty of care essentially says, ‘What’s the appropriate level of care?’ Whether that’s gross negligence or ordinary negligence or something else that can create liability.

The duty of loyalty basically deals with self-dealing transactions. When I do something and it benefits me and maybe it benefits the LLC or maybe it doesn’t, but I’m engaged in some form of self-dealing.

Then the obligation of good faith and fair dealing kind of comes out of contract law.

What Delaware essentially says is — you can waive or eliminate the first two duties: the duty of care and the duty of loyalty. You can’t really make the obligation of good faith and fair dealing go away because that’s contract and you’re still dealing with contracts.

So oftentimes people want to go to Delaware because they either want to modify the fiduciary duties which — you are limited in doing in California — or they simply want to eliminate them.

The last component, the last thing you’ll hear about why people like Delaware law is: If you have a dispute in California, you’ll go to California Superior Court and that’s kind of a court of general jurisdiction. There will be criminal cases and civil cases and a lot of other things. Delaware has a court of chancery which is only business disputes. So chancery court is seasoned business lawyers and litigators resolving business disputes.

As a result, not only does the law evolve faster but it tends to evolve, in some sense, in a more logical progression, because the chancery court often sets a policy and then goes about enforcing or invoking that policy. So the opinions tend to be perhaps a bit more forward thinking, in that not only are we making a decision now but we’re really setting a policy for future decisions.

What about transparency?

That’s an attractive element of Delaware. In Delaware I can create an LLC and I only need to say who the registered agent is and where my registered office in Delaware is. I don’t need to say who my owners and my managers are. So as a result, Delaware only has one file — ‘Here’s the name, here’s the registered office,’ which is typically the registered agent — and that’s all that’s there. So from an anonymity standpoint, Delaware is the highest level of anonymity. There’s nothing that reflects ownership there.

In California, if an LLC is member-managed you’ve got to list who the members are — name and address. If it’s manager-managed, then you’ve got to list who the managers are — name and address. And most states have that, where you’ve got to give one or the other. You can’t have complete anonymity.

But Delaware, like I said, is really unique in many respects in that I can create a Delaware LLC and there’s really nothing you can glean from looking at my public filings to find out who’s behind this LLC.

So in Delaware, they only have to list the registered agent and the address?

Right.

Is it assumed that that registered agent at that address keeps all the information about that LLC? The bylaws, the members, etc.?

No. They don’t. All they have is contact information, so if they get something in the mail, they know where to forward it to. But no, generally they don’t keep any of the documents with respect to the LLC. There’s nothing there. There will be offices with 50,000 LLCs using it as a registered agent and a registered office and there’s nothing there other than, ‘Here’s the contact person for this LLC.’

So if you’ve got a client that wants to remain as anonymous as possible, Delaware is generally your first choice.

Isn’t this a bit of a concern? Cracking down on tax fraud, foreign influences?

Yes, it’s been a concern.

On the one hand, there have been numerous proposals to disclose that information. But on the other hand, you have to kind of admit that there’s certainly a group or an industry that likes the anonymity associated with it and they are going to resist any type of disclosure like that. It’s been talked about probably more so from the administrative law standpoint but quite honestly there’s never really been any legislation to require it. There’s a sense that the political will isn’t necessarily in place to be able to do it. So if it’s going to be done it’s going to have to be done through someone other than a legislative body.

There’s probably no country that protects the information stronger than the United States. We tend to want to keep this information confidential but want everyone else to disclose their information.

It’s always curious to me, particularly in regard to my UK clients where, in that country, there’s a public database on who owns any entity. You can literally log in, you can see who the shareholders are, if it’s an LLC you can see who the members are, and it’s completely open and transparent. Whereas in the U.S. it’s almost the exact opposite.

In your experience, what are some nefarious ways people use LLC anonymity to skirt laws and take advantage of loopholes?

There are a couple layers of concern. I think the federal government is always worried with respect to money laundering and wire transfers of LLCs because, quite honestly, there’s no public information as to who the real owners are, particularly if it’s a Delaware LLC. So I think there’s always been a concern on their end.

Is there anything else that I should be asking about?

No, you’re asking good questions.

This has been an ongoing issue, we saw this very much so post-9/11 because you had instances where money was moving in and out of the United States and nobody knew who the ultimate source was.

You’ve seen it a little bit post-Patriot Act where all of a sudden Congress told the banks, “You need to know who your customers are.” It continues to percolate on both the federal and state level. But it never seems to move beyond the discussion point — why is it so much different here than it is in many other places in the world? Why is there a call for transparency in other places when we don’t have that level of transparency here?

It’s an ongoing issue that tends to ebb and flow over time. Post Panama Papers you saw this ramp up, but like everything in the news cycle, it’s first and foremost for a week or two and then seems to slip away. And neither the states nor the federal government seem to be that interested in pursuing it.